Kudlow: A very special evening here. The man in the eye of the financial storm. Treasury Secretary Henry Paulson joins me live here in our nation’s capitol. Thank you very much for coming back.

It’s a tough day. You know all about that. The market is down over 700 points. Your announcement was yesterday, but we still have the bumpy markets. Fear seems to rule. Volatility seems to rule. A lack of confidence everywhere. Let me ask you, sir. Are markets missing something with respect to your new plan? How do you comment on this, because it just doesn’t seem like there is a wave of confidence.

Paulson: Well, Larry, there’s a lot going on right now and a lot going on in the markets. We knew that the financial markets and all the turmoil in the financial markets were going to have a significant impact on the real economy.

Today there was some evidence of that. The retail sales numbers came in at a disappointing level, but not a surprising level. So, I think what the markets are saying today is that they understand that we are going to have a difficult few months ahead of us. But what I would say is let us remember that we have a very resilient economy. Last quarter we grew at 2.8 percent.

The steps we’ve taken are absolutely the right steps. They are bold steps. They are strong steps to stabilize the financial markets and inject confidence into the banking system along with capital. When banks start lending to each other, feel comfortable dealing with each other, they will start lending to businesses and we’ll see this make a big difference in the economy.

Kudlow: Do we have to take a recession? Are we in a recession right now, sir?

Paulson: Well, Larry, what I'm saying is, we're clearly in a difficult period, and it clearly -- the financial turmoil and the very, very difficult time we've had where the credit markets have frozen up, and when loans weren't being made, weren't being made to small businesses, people -- it was hurting jobs, it was hurting confidence, and this has to have an impact. And it's having an impact. But by far the most important thing we can do here is stabilize the markets, stabilize the banking system, and I'm very confident that the moves we've done, taken, will do just that.

Kudlow Video: Paulson on the markets pt 1

Kudlow: All right. I want to get into all those things. They are very important points. Let me begin – front -page stories in all the major papers today. When you unveiled on Monday your rescue package to the nation’s top bankers, apparently it was a somewhat contentious meeting. I want to ask you, first of all, are the major bankers with you? Are they on your team for the rescue package? Second of all, what was the biggest bone of contention in that meeting? What was it you had to sell them on?

Paulson: Well, Larry, let me begin by saying I don’t believe it was a very contentious meeting. I think it was a candid meeting. I think it was pretty extraordinary to get nine bankers running key institutions – institutions with 54 percent of the assets, 50 percent of the deposits in the United States of America -- and to get them to sign up for this plan.

What I said to them was – this is about the United States of America – it’s about our economy – it’s about our banking system and this is a program for healthy banks. This is not about failure. We want healthy banks to participate in this, because healthy banks need to be well capitalized. They need to be dealing with other healthy banks and with businesses. They need to be deploying their capital. This will be good for the country, it will be good for the system, and good for all of you.

Kudlow: How did you persuade my friend Richard Kovacevich, who runs Wells Fargo? He seems to be the most prominently mentioned. I wasn’t at the meeting and he didn’t talk to me, but from the news accounts, how did you talk him into coming on board?

Paulson: Well, I’ve got to say this. We talked to everyone and there are institutions that could survive just fine without more capital – they have adequate capital – but they need to be well capitalized. What we want to do is to come up with a program. Remember something else about this program. There is nothing punitive about this program. This is a program that said to all the investors that want to come into the banking system, that when the government comes in it is not coming in to squash private investment.

Kudlow: Private shareholders.

Paulson: Private shareholders. No, it is encouraging private shareholders to invest in these banks. So, this is about increasing confidence in the banks and about increasing confidence of the banks and the banking system so that they can be proactive in deploying their capital.

Kudlow: Did some of these bankers worry about management control exercised by the Treasury Department? I mean clearly there are limits to executive compensation. There are limits with respect to dividend payments. And there are generic issues -- will you exercise your warrants and will you exercise voting strength. In other words, is this nationalization? I think that’s on the minds of a lot of people.

Kudlow Video: Paulson on the markets pt 2

Paulson: Well anything but. Anything but and this is about taking the preventative action so we don’t need to do any more radical things. Let me just take the issues you mentioned one at a time. These are relatively small positions in ownership terms. These are passive investments. Management -- this is not anything like what you suggested.

In terms of executive compensation, there was broad agreement in that room that this is an important topic. No one spent time debating executive compensation. I explained what the law required and that we were going even further and that there wouldn’t be golden parachutes. If there were profits based upon financial information that turned about to be materially misleading, that compensation would be given back.

Kudlow: Both of which the country seems violently opposed to – the political nature of the country right now is so much against that kind of thing.

Paulson: And also that we couldn’t have incentives that made compensation based upon excessive risk-taking. All of those CEOs in that room understood it. As a matter of fact, when I outlined it, one of the CEOs said “Hank, why are we even spending time talking about this? Of course, we get it.”

Again, these are investments that are good for the country and good for the banks. These are temporary investments to bolster confidence and to bring capital to the system. It will be deployed and the economy will pick up and these investments will be refunded.

Kudlow: Do you think that with the preferred stock and all the other aspects you just described – really, you say passive investments, not active management control – will that attract private shareholders and private capital, not just the shareholders today, but the potential shareholders tomorrow?

Paulson: Absolutely. I think where people have gotten confused is there have been situations where we’ve had to come in where there is a failure. That is a totally different proposition.

Kudlow: AIG. Fannie and Freddie.

Paulson: Yes – that’s failure. That’s where you have to come in. This is about attracting private capital and it was clear to the whole world that these preferred share investments are going to come in right alongside other senior preferred and not senior to them. And again, preferred doesn’t vote with common shares. The warrants are for 50 percent of the value of the preferred shares. And again, the warrants are for non-voting common shares. So, this is about capital and protecting the American people by getting our financial system working the way it’s supposed to work. So, we’re going to be able to create jobs. This is about people’s 401k plan. This is about loans to send their children to college and keeping our economy going. That’s what it’s about.

Kudlow: So many people want to know. People stop me on the street – callers on my Saturday radio show – how can you get the bankers to deploy the government capital that you are injecting? For example, the yield on the preferred is 5 percent. Their cost on the preferred is 5 percent. Some of them have preferred stock that is 11 percent in yield. They have bonds outstanding that are 7, 8, 9, and 10 percent. What is to stop them from getting new government money at 5 percent and retiring the outstanding paper that is much more expensive, rather than deploying this new capital in the economy for the purposes you just described?

Paulson: Well, that's a key question, and let me say, even before that, the reason we set the terms where they were set, we didn't think this term should be set at what the market would demand in a crisis situation. That's why the government's coming in to begin with. We wanted the terms to be like what you would have in a normal situation.

Now, the way you get bankers to deploy the capital -- because they know it's their job to deploy the capital, making the loans which are so vital to our economy -- the way you get them to do that is they've got to have, first of all, plenty of capital; they've got to be well-capitalized. Secondly, they've got to be confident in the system. They've got to be confident that as the money flows between and among banks that they're confident in that and confident in the strength of the system.

Kudlow: Rather than pay down their own debt.

Paulson: They’re not going to be paying down their own debt. The regulators understand that and they understand that.

Kudlow: Will you jawbone from time to time -- that's a bad word, jawbone -- will you be talking to them in consultation as you did on Monday, for example?

Paulson: I will clearly be doing that, but I will also say to you that they understand this, and regardless of whether we had government investments there, we would be jawboning and encouraging them to do the right thing. And I will say it will be a lot more effective if people aren’t afraid. This is about confidence and confidence in the financial system.

Kudlow: Mr. Paulson, let me just ask you another question that I hear a lot. People are relieved that you are guaranteeing, the FDIC that is, is guaranteeing the interbank lending. The LIBOR markets are frozen up. Some say the New York markets are frozen up for the short-term loan. That’s a huge drag on the whole system. But, let me ask you this – when does this guarantee actually go into place? There is a 75 basis point cost that the banks have to pay. I assume there is some registration. LIBOR rates have slipped a little bit, sir, but not very much. When does this guarantee for the interbank loans really kick in?

Paulson: Larry, I think when you do something as quickly as we rolled this out, there may be some confusion in the marketplace. But, everyone has a guarantee for 30 days. So, there’s a 30-day guarantee.

Kudlow: Immediately?

Paulson: Immediately.

Kudlow: Do people know this key point?

Paulson: They should, because the guarantee is there immediately. At the end of the 30 days they need to subscribe to this. There is a 75 basis point fee. Then, if they subscribe, the guarantee lasts through June of next year. The guarantee applies to the senior obligations coming due – unsecured obligations – and they can refund those with a maturity out to three years.

Kudlow: Talking about the freeze up in London and New York and elsewhere, with the benefit of hindsight, was it a mistake to let Lehman go under? Because a lot of people are saying it was precisely the drop off in Lehman, which was roughly in early to middle of September when suddenly LIBOR rates went up, the spread against U.S. Treasuries went up something like 300 basis points and the whole system seemed to go haywire. The whole system was like a computer that completely froze up and there was nothing anyone could do about it. Was the Lehman decision an error?

Paulson: Let me talk a little bit about the Lehman situation. Some of you could argue -- are we dealing with a symptom or are we dealing with a root cause? Because one thing I saw clearly this weekend when we met with central bankers and finance ministers from around the world. There was something very good that came out of that weekend, which was the way in which we all agreed to work together with a common set of policies and objectives. The thing that wasn’t as good was to understand the extent of the problem with financial companies and banks in country after country where they said they didn’t have a real problem, to suddenly then have a significant problem.

But let me get back to Lehman. First of all, Treasury didn’t have any powers to do anything as it related to Lehman. We’ve been very clear. I’ve been very clear when I talked with Congress in July that we didn’t have the authorities to deal with a wind down of a non-bank financial institution. So we were very, very clear about that.

Kudlow: But in truth sir, weren’t you deeply involved in the wind down of Bear Stearns last winter?

Paulson: Yes, working with the Fed and the Fed could loan – under 13-3 – they could loan against securities. But there was a hole that needed to be filled in the case of Bear Stearns. There was a buyer, J.P. Morgan. and they could loan against securities.

We worked very hard on Lehman. We all knew about the problem with Lehman for a long time and Lehman tried to work through their problems. I think regulators knew that if there was not a solution before they announced their third quarter earnings, there was apt to be a problem. It turns out there wasn’t a buyer. There was no hole to fill. There just was not a buyer for Lehman. And, the Federal Reserve didn’t think they had the authorities to loan (under 13-3) against Lehman. And I certainly wasn’t urging that because, again, we had a system where we have authorities that were put in place a long time ago for a financial system that existed in a different world and there are broad authorities if a bank fails.

Kudlow: But in truth, when you go back and look at it, the stock market is down 25 percent since Lehman, which was really just a few weeks ago. It was an extraordinary event and, at the time, some people applauded you and said enough is enough we can’t take out every bank. But in looking back on it, that seemed to be the trigger to all this recent mayhem.

Paulson: I would say, Larry, looking back there’s a lot that happened. What was going on with Lehman, there is no doubt that when you look at the over-the-counter derivative markets, when you look at the complexity of today’s financial world, a failure of any big financial system creates a big issue.

I always look back, in addition to looking forward and deal with the facts presented to us. But I could not have been clearer in June and July, that we didn’t have the authorities. And, we certainly didn’t have them at the Treasury and I don’t believe the Fed had them. If there was a buyer for Lehman – we had a foreign buyer that was interested – but near the end their regulator wouldn’t let them. So, there was no buyer. There was no hole to fill.

Kudlow: Let’s move on. When you made your statements yesterday regarding the unveiling of the new rescue program, here’s what you said and I will quote. “We regret having to take these actions. Today’s actions are not what we ever wanted to do.” What did you mean by that?

Paulson: What I meant was, you know, we’re from the United States of America. We believe in free markets. We expect our markets to work well. Government intervention is about failure of a regulatory regime, mistakes on a lot of people’s parts, but to me this was much, much better than the alternative. And this was about preserving our free market system and preserving our banking system and stabilizing it for the American people. There’s going to be a good deal of work that needs to be done once we get through this period and a good deal of work to make sure we don’t get like this again.

Kudlow: Some people read your statement and they wondered out loud – did you mean the changeover in policy from the Treasury purchases of toxic assets to the new capital injections?

Let me read you what you told the Senate Banking Committee – this is just a couple of weeks old – in a very difficult Congressional battle, which you eventually won. “There were some that said we should just go and stick capital in the banks. Put preferred stock – stick capital in the banks. And what to do when you have failures, you know, that what happened in Japan and other spots. But we said the right way to do this is not going around and using guarantees and injecting capital. There have been various proposals to do that, but we want to use market mechanisms.”

What was it that made you shift your emphasis away from the toxic asset purchase and towards the injections of capital?

Paulson: Larry, I’m glad you asked me that question. Let me begin by saying that what we were talking about was always capital. Going back over a year ago, I did everything I could to jawbone institutions to raise capital. No CEO ever got in trouble by having too much capital. The illiquid asset purchase is about capital and about price discovery and freeing up capital. We’re going to do illiquid asset purchases and it’s going to be integrated very well with the program.

When we worked with Congress we knew we were going to have the ability to purchase preferred stocks if it was necessary. But that statement I made then was about putting in capital if we dealt with a situation like Fannie or Freddie or AIG or we had to move to prop up a failing institution.

Kudlow: But some people are saying that the movement of Europeans toward capital injection, the movement of the British toward capital injection, essentially forced you to play your hand. Is there any truth to that?

Paulson: I look at it differently here. You always need to look at the facts, then the facts before you determine what you do. What we’re doing is very different from what the British are doing. It was clear to me after spending time with the Europeans and what was happening there – learning more about this situation, that the problem was bigger than we had hoped and that the right way to make a big impact quickly was by purchasing preferreds on the terms of which we did it. That would make the taxpayer money go the furthest. This was clearly an investment where we should get these funds back with a profit.

We moved quickly, but remember let’s just talk about what we’ve done. In just twelve days after the legislation was passed, we had the nine institutions (voluntarily) with 50 percent of their deposits in the United States sign on for a program.

Kudlow: For $125 billion

Paulson: $125 billion

Kudlow: And you’re going to go for a second $125 billion

Paulson: And then we are going to go broadly to other financial institutions and we’ll be going to regional banks and smaller banks and community banks.

Kudlow: That leaves only $100 billion out of the authorization of $350 billion. Is that where the toxic asset purchase comes from?

Paulson: Remember, we have $700 billion.

Kudlow: But you have to go back to Congress for the remainder.

Paulson: For the next $100 billion, all the president has to do is notify. Then, to go beyond that, there is a notification process and Congress has the ability, obviously, to pass legislation to prevent it. In terms of the illiquid assets, this is a $250 billion purchase of preferred equities and it gets very different from what we were talking about when we were talking to Congress. This is a way in which to encourage shareholders to come in and not the way in which I answered the question where we were talking about injecting preferred on a punitive basis.

Kudlow: We talked earlier about the recession or the downturn and the difficult position with retail sales falling three straight months. We really have unprecedented commodity deflation, credit deflation, home deflation, and all the rest of it. When do you think realistically that new credit will flow to consumers, to businesses, to state and local governments? When do you think Americans can realistically expect that to happen?

Paulson: Larry, that is the important question and that, more than anything else, will make a difference in this economy. I’ve said we have a resilient country and a resilient economy and it can bounce back and this is about confidence. We’re going to have a number of difficult months here. We’ve taken the actions that I believe are the right actions based upon the facts that we looked at this week. I think they are the right actions and I think they can make a difference and they can make a difference more quickly than many people recognize, but it’s going to be confidence.

Kudlow: Whoever wins in November – we’re a few weeks away – would you be willing to stay on for a few months to keep this process intact before you hand it over.

Paulson: Larry, I’m going to work day and night through January 22 and right after the election I’m available to work with the best transition you’ve ever seen – with whoever the new Treasury Secretary is. We’re out looking right now for permanent leaders of this TARP and we’re looking to get someone that will be more than acceptable to the next president and his economic team. This is going to be a first-rate transition --I can guarantee you that.